Chances are you keep at least some, if not all, of your money in a checking or savings account (or both).
Chances are you have at least one credit card (if not, you should fix it ASAP).
Chances are you have or once had some sort of loan – be it a student loan, a car loan, a mortgage, or perhaps all of the above.
Although you will certainly recognize that these are products offered by banking institutions, you may not have known that none of them are free. Banks have to stay afloat somehow, and they do it in subtle ways, like the monthly maintenance fee on your checking account or the interest on your car loan.
Below, we’ll outline how banks make money so they can continue to help you manage yours.
How do banks make money?
When you think of a bank, what comes to mind? Checking accounts? Credit cards? Credits? Banks provide a wide range of services, but the most common (and most important to you and me) fall into two categories: money held for customers and money lent to customers.
Banks must earn some income from these services, and they do so in two main ways.
Fees
Fees are the primary way banks make money from the cash they hold for customers.
For example, if your checking account is charged a monthly service fee, it is part of that bank’s income. If you have recently traveled abroad, you may have noticed a fee for using your credit card abroad. This is a foreign transaction fee and another way to earn money.
Here are some examples of bank fees, many of which you’ve probably already paid:
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- Monthly maintenance fee
- Credit card fee
- ATM commission
- Foreign transaction fees
- Overdraft fee
- Exchange fee
- Creation fee
- Late payments
- And so on…
Read more: How to stop paying ATM fees
Interest
The interest lies in how banks get money back for the cash they lend to individuals and businesses.
When you borrow money from a local bank, for example to buy a new car, the bank is not doing you a favor; they provide a service and you have to pay for that service. The main way to pay off the bank for lending you money is through interest.
Some of the products that banks charge interest on include the following:
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- Home loans
- Auto loans
- Personal loans
- Business loans
- student loans
- Payday loans
- Credit card debt
- And so on…
Other income streams of the bank
While banks make a significant portion of their income from various fees and interest, their income is, in truth, much more diverse.
Banks also provide services in the capital markets, which essentially means that they work with investors and businesses that need help with various financial transactions. Some clients may need help financing a project. Others may need help with underwriting and/or equity creation. Other businesses may need the support of an advisor or group of advisors in a merger or acquisition.
Services in the capital markets are diverse, but they are also inconsistent. This is why many banks rely more heavily on commission and interest income.
Do all banks make money the same way?
In short, no.
While many banks generate the bulk of their income from interest and fees, the weight they place on different income streams varies. This is due to the fact that banks offer two types of services: commercial and investment.
Some banks focus on commercial banking. Some focus on investment banking. Others, but not all, offer products that fall under both categories, and those who do may be able to make more money with one type of banking than the other.
Knowing what your bank offers will help you understand why they charge interest and the fees they do.
Commercial banking
Commercial banking is probably more familiar to you because commercial products are available to individuals and small and medium businesses. In fact, when you hear the term “bank”, it most often refers to a commercial bank. Products offered by a commercial bank include deposit accounts (checking and savings accounts) and loans (car loans, home loans, etc.).
Read more: Which banks are the best?
Investment activities of banks
Investment banking refers to products and services for the “big boys”. We are talking about corporations, wealthy people and even governments. These institutions offer financial advice and asset management, trading activities, etc.
What about credit unions?
At first glance, it may seem that credit unions and banks are almost the same, and in many ways they are. For example, both charge customers interest and fees. However, one notable difference is that credit unions are non-profit enterprises owned by their customers, while traditional commercial banks are owned by shareholders.
Read more: Credit unions vs. banks: think locally, save money?
The reason this difference is important in terms of making money is because credit unions only make enough money to cover their own expenses, while banks are actually trying to make a profit. Consequently, credit unions are generally able to offer lower commissions and interest rates to their clients.
That being said, one of the main disadvantages of working with credit unions is that they tend to be smaller than commercial banks, which means they have fewer branches to work with and fewer products.
Read more: Top Credit Unions
How to cut your banking costs
Now that you have a clearer picture of how banks make money, you can identify opportunities to cut those funds. Here are two simple suggestions to reduce your bank charges:
Pay attention to bank fees
While every bank must charge fees and interest to stay in business, there are plenty of “free” services you can consider to cut costs.
For example, online banks can maintain lower costs because they don’t have to pay for physical branches. As a result, they can reduce or even eliminate certain payments, such as monthly service fees.
Read more: Online banking vs traditional banking
Another fee that is easy to avoid is the overdraft fee; all you have to do is opt out of your bank’s overdraft protection and make sure you keep an eye on your account balance so you don’t spend more money than you have.
Read more: Overdraft and commission protection
Shop Before You Buy
Banks may sell similar products, but not all of them charge the same rates and fees.
As mentioned earlier, for example, online banks can offer customers reduced fees because they don’t have to pay for physical branches. With that in mind, before opening a new credit card or taking out a personal loan, make sure you spend some time researching and comparing options.
Read more: How to choose a bank
Summary
Believe it or not, your bank is charged.
Banks need to make money to stay in business, and they do it in a number of ways. If you have a current account, you pay the bank a fee for keeping cash. If you have a personal loan, you pay interest to the bank to borrow money. But not all banks have the same income streams and understanding how your bank making money can help you learn how to cut costs for yourself.
Featured Image: Dmitry Lobanov/Shutterstock.com